The leveraged loan and collateralized loan obligation (CLO) markets have been on a tear so far this year, even outstripping growth in private credit and private-credit CLOs, two markets whose rapid growth has sparked concerns about the impact on traditional syndicated lending. Those fears have been dispelled, for now.
As of June 21, $660 billion in leveraged loans were inked, up from $124 billion during the same period last year, according to the Loan Syndications & Trading Association (LSTA), with refinancings and re-pricings accounting for 91% of that activity, compared to 78% last year, rather than new money stemming from M&A activity,. A big driver of that growth was a highly active CLO market, fueled in part by $191 billion in gross issuance as of June 17, of which more than half was new CLO issuance.
"CLOs are approximately 65% of the institutional term loan market, so when the CLO market is active, especially on the new issue front, that creates opportunity for the corporate loan market to be active as well," said Sean P. Griffin, who was named executive director of the LSTA in April.
Griffin moved over to the LSTA after 22 years at J.P. Morgan, where most recently he was managing director responsible for the global primary CLO business, including originating, structuring and distributing CLOs for issuer clients. He recently spoke to Asset Securitization Report about key trends and developments in the leveraged loan and CLO markets, and the issues the LSTA is monitoring.
One of the data points I like to look at to determine how much of the corporate loan market can be refinanced is how much of the secondary market is trading above par.
ASR: Where do you see the two markets heading in the second half 2024?
Griffin: It should be busy but could slow down if we don't have more M&A and leveraged -buyout activity to fuel new issuance of primary loans, and that could impact the CLO market.
ASR: How long can refinancing/repricing activity continue?
Griffin: It's ultimately up to the borrowers, but Bloomberg recently reported an average margin reduction of 50 basis points on those transactions, and that's a reasonable amount of spread to shave off your credit margin.
One of the data points I like to look at to determine how much of the corporate loan market can be refinanced is how much of the secondary market is trading above par. As of mid-June it was 40%, off this year's high of 64%, and that makes sense because we've seen a lot of refinancing and repricing activity, with Q2 being the most active quarter on record for refinancings. If a lender sees a secondary-market loan that pays a 450 bps spread for a single B credit, for example, and new issue single Bs are paying 350 bps, the lender may be willing to pay above par to get that above-market coupon, and borrowers recognize there's an opportunity to bring that spread down. We're starting to see less of that dynamic given the pace of refinancings and the decrease in secondary loans trading above par.
ASR: How could that impact CLOs?
Griffin: As we've seen loans reprice and refinance and spreads come in, we've also seen CLO-tranche spreads come in. We're quickly approaching the point where new issue CLO AAAs are pricing at 135 basis points, down 15 basis points from the start of the year. If credit spreads come in faster on corporate loans than on CLOs, you could start to see a slowdown in CLOs, because the loans are paying less and the CLOs have to pay more on liabilities, making CLO equity less attractive. We haven't seen that yet, and CLO equity remains attractive, but loan spreads continuing to compress could be a headwind.
ASR: Do you see an adverse impact on CLOs if interest rates remain high?
Griffin: Corporate balance sheets continue to be healthy. Higher rates for longer can put more stress on companies and that could lead to an uptick in defaults, but so far default risk has been very idiosyncratic, and excluding some fundamental shift in the economy, we would anticipate that remaining. We have the fortunate foundation of a strong economy and open capital markets, so borrowers have been able to shave basis points off their cost of funds, which to some degree offsets the higher-for-longer rates.
ASR: What is a key issue today for the LSTA?
Griffin: The concept of liability management exercises and how they impact recoveries has been very topical. When a limited group of senior lenders provide additional capital to the company that's senior to the existing first-lien loan, without giving the other first-lien lenders the opportunity to participate, that's where tensions can arise. Anything that starts to drag down corporate recoveries overall can have a knock-on effect on how lenders on the loan side and CLO tranche side price risk.
ASR: Has private credit played a role in those transactions?
Griffin: It's generally been seen in the syndicated market. Private credit lender groups tend to be consolidated and involved in a number of transactions together, so it could happen but the rate of occurrence is much less.
Increased capital inflows into private credit is good for borrowers, because it means more capital is available to them that generally results in some economic consideration.
ASR: Will private credit capture as much as 30% of the CLO market in 2024, as some projected last year?
Griffin: This year through mid-June, private-credit CLO issuance was 20% of overall CLO issuance, and last year at the same time it was 22%. The difference this year is that the broadly syndicated loan (BSL) market has been meaningfully busier than most people anticipated, and there's been more CLO issuance than expected. That said, there's been $25.4 billion of private credit CLOs over that period, and last year it was only $11.9 billion. So it's a smaller percentage, but not because private credit is doing less. There's just so much BSL volume that it's hard to reach that 30%.
Given the amount of equity capital raised to support private credit, and CLOs as an important part of private credit's funding and leverage, I fully expect private-credit CLOs to be an important part of private-credit formation and a growing portion of the CLO market.
ASR: How do you see the relationship between BSL and private-credit CLOs unfolding?
Griffin: I envision a continuing ebb and flow between the two markets. When the BSL market is open, companies that can tap into it will likely do so because going through the capital markets exercise gives them lower credit spreads and friendlier documentation. Borrowers choosing the private route get a faster financing solution and they may want a smaller lender group that gives more certainty of execution. The trade-off is they end up paying a higher credit spread, but we're seeing those spreads compress today across both BSL and private credit.
Increased capital inflows into private credit is good for borrowers, because it means more capital is available to them that generally results in some economic consideration, such as tighter spreads.
ASR: What role do you see the new CLO ETFs playing?
Griffin: Anytime a new type of investor enters a capital markets space, or an existing investor expands is presence, it's incrementally positive for the asset class. However, the largest CLO ETF just passed $10 billion, and it's about 90% of the CLO ETF market. So while those ETFs are helpful, they're not a main driver of the spread compression we're seeing right now.
ASR: What else is the LSTA monitoring?
Griffin: There are a number of issues happening away from the capital markets, such as where the Federal Reserve is going with rates and a range of geopolitical events and an upcoming election. So while there's nothing immediately concerning, markets should be keeping an eye out for potentially increasing volatility later in the year.
